While reading the Aleph Blog recently, I was shocked to see an author whom I respect say that Bernanke’s policies “discriminate against the poor, and the lower middle class”, because the poor do not know how to invest, and are leaving their cash in the bank to be eroded by a negative real rate. I think that Bernanke’s policies actually do the opposite, discriminating against the rich and favoring the poor. The typical low/middle-income guy doesn’t care whether the $20k in his bank account is yielding -2% or 5% real interest. Either way, he is not going to able to survive on that income. Way more important to him is that he has a job. A zero Fed funds rate actually makes life harder for the moneyed class, who can no longer live off interest from a safe asset like Treasury bond, and are pushed to acquire real assets to protect themselves from the inflation. In so doing, they increase the demand for real assets in the economy, and more people are hired to produce the goods demanded, and the average poor guy gets a better shake in the employment market. So Bernanke, in my book, is doing the poor guy a favor.

But the more interesting question is : What is the correct “natural” rate of interest that can be expected from safe, liquid, cash-equivalent assets (bank accounts, Treasury bonds etc.)? Is it unfair that Bernanke is “artificially” depressing that rate down to zero?

To answer that question, we would have to lift the veil of money to reveal the fundamental nature of saving. Imagine a world without money, where people exchange goods through bartering. In this moneyless world, people would still want to save, that is, to consume less today so that they can consume more tomorrow. The only difference is that without money, they would have to save real goods. There are two fundamentally different ways to save. The first way is through storage. Simply stash that bushel of wheat in a warehouse, and one year from now, you can eat more wheat. Storage is a form of savings that is intrinsically yields a zero or negative rate. At best, you get back whatever you put in. At worst, your goods gets stolen or burns down. But there is a second way to save, which we’ll term investing. The farmer can, for example, experiment on new strains of wheat on a small portion of his land. During this period, his plot is producing less wheat than usual, because some resources are devoted to experimental strains, some of which can fail, so he is consuming less wheat today. But, assuming that the experiments are successful and he comes up with a wheat strain with greater yields, he reaps more wheat tomorrow. Investing carries the possibility of a positive interest rate; it is entirely possible that you can reap more than you put in. However, it is also a RISKY and ILLIQUID endeavor; it is also possible that you lose all that you put in, and you typically cannot terminate the endeavor without losing all you have already invested.

During normal economic times, with all resources already productively employed with little spare capacity, much of the saving in the economy is actually investing, which has an intrinsic positive yield (assuming risk is handled properly). Resources are simply too expensive to be stashed away in a warehouse somewhere. And that positive interest rate feeds through the entire financial ecosystem, such that even “riskless” financial assets like Treasury bonds and cash yield some small but positive real interest rate. But in a recession, where there is spare capacity and resources, some portion of saving in the economy becomes storing, which intrinsically carries a zero or negative interest rate. And in the financial ecosystem, only those that take risk deserve a positive real return. If you are very risk-averse in a recessionary environment, you should not be shocked to get a zero or negative real interest rate. Banks globally are having problems finding enough credit-worthy people and company to lend to in the midst of a recession, and therefore are stashing their money with central banks or in gold. Some banks are even turning away deposits. In this environment, there is no reason why riskless financial assets should yield anything at all. Bernanke can no more give the risk-averse a positive real rate than he can wave a magic wand and dispel the recession. (Well … actually he can, but not without harming other people.)

From the perspective of society as a whole, risk taking is the only important thing. Without risk taking, any kind of monetary policy is just a zero sum game, dividing the same fixed pie in different ways. Tighten policy to cause deflation, and those with liquid cash assets win. Loosen monetary policy to cause inflation, and those with cash lose while people with hard assets and the working poor win. But in the end, you’re just pushing the same amount of chips to different people. So, why not use a bit of financial coercion to get people to take risks again. Leave your assets in cash, and you lose 2% a year to inflation. But hey, if you take some risk and say buy stock, buy a house, start a company, or heck, even buy gold, you protect yourself against inflation and stimulate the economy at the same time. And I think we can all agree that growing the pie for everyone is a better economic objective than squabbling about who gets a bigger slice of the pie.

P.S. The above is simply a long-winded explanation of the economic concept of the “natural rate of interest”.

Recently, SODA inked a deal with KFT, in which SODA will begin selling carbonated versions of some of Kraft’s beverage brands, including the Crystal Light and Country Time Lemonade brands. The stock immediately spiked around 10%, probably prompted a rush of short covering, of which I am a tiny part of. I covered because when a stock with a 50% short interest releases positive news, a short squeeze is a very real possibility. Again, I am reminded that shorting stocks is very much a timing game, much more so than being long. Still, I have no complaints, having a profit of around 10% overall from my SODA short because I shorted initially in the upper $40s, despite covering one-third of my position at a loss in the $60s.

My core thesis that SODA is a faddish niche product is, I believe, intact even in the face of the recent announcement. As far as I am concerned, anyone who wants fizzy versions of Crystal Light or Country Time Lemonade can simply add the Kraft powders to soda water instead of paying SODA’s markup as a middleman. It should be noted that SODA’s machine is simply an inconvenient and laborious way of generating carbonated water, easily available cheaply in ready-made form at any supermarket. Of more concern is the fact that Costco has started distributing Sodastream machines. This was of some concern to me, since I believe that the lack of places at which to exchange SODA’s carbon dioxide canisters is a major stumbling block in their bid to reach the mass market. But as far as I can tell, Costco is simply selling the machines and not exchanging the canisters.

In addition, there are some signs that SODA is being manipulated, likely by call writers. For the past several months now, SODA has reached a peak in price in the middle of the month, shortly before options expiration Friday, and then proceeded to decline towards the end of the month, only to begin the cycle again in a new month. Academic research has suggested that stock prices tend to be pinned at a point where the total value of options contracts (both calls and puts) is the lowest, a hypothesis dubbed the Max-Pain theory. Both large and small stocks can be subject to option manipulation; the common factor is avid interest among retail investors, who tend to buy lots of call options at rich premiums for these stocks. Since the major danger in this strategy is that the stock may skyrocket, causing massive losses to call writers, stocks with poor fundamentals are reasonably good candidates for this strategy.

As the stock has now declined to near reasonable prices, I have switched to a more opportunistic mode of trading this stock, shorting highs and then covering at the end of the month.

Disclosure : I have a short position in SODA.

A recent article in The Atlantic asks the interesting question : Why is there a single price for movie tickets? We have different prices for airplane tickets and Broadway shows; why don’t theater owners use different ticket prices to manage demand and keep their venues packed? The article points out that the single price system is not all bad for theater owners. Theaters keep their venues full by allotting an appropriate number of theaters to the movies, not by charging different prices. Flexible prices could lead price competition between theaters, to their collective detriment. It also increases policing costs, since people will be tempted to buy cheap tickets and sneak into expensive movies. However, the article fails to mention the main reason for the single price, that is, the market power of the distributors. The Big Six majors, namely Paramount, Warner Brothers, 20th Century Fox, Disney/Touchstone, Columbia/Tristar, and Universal Pictures, wield enormous clout in the movie business. By maintaining a single price regime, they keep the movie theaters dependent on the big budget films that only the majors have the financial muscle to pull off, and thereby are able to negotiate a bigger cut of the ticket prices. And allowing flexible prices could allow independent films to gain a foothold in the theaters, threatening their lucrative franchises.

A brief history of movies

To understand how this state of affairs came to be, it is instructive to briefly examine the history of the movie business. The movie technology matured in the early 1900s, with the first movies with soundtracks appearing in the 1920s, and the first color movies in the 1930s. The early movie industry was vertically integrated by necessity, since companies had to invent every aspect of the movie business, from making movies to distributing them. Cinemas showed only the films of the studios to which they belong, and actively avoided competing with each other by scheduling films so that they do not compete head on. Studios had a chokehold on the creative and acting talent, and films were low budget and generally of low quality. This state of affairs came to an end in the landmark anti-trust case United States v Paramount in 1948, which forced the studios to break up. The studios naturally chose the least profitable parts of their empires to divest, and spun off their production and cinema businesses. From then on, the movie business was split into 3 parts, The studios contracted out the actual movie making to independent production companies, and contracted with independent cinema owners to show the movies at the theaters. But they kept the most profitable part of the business for themselves, becoming movie distributors who market, finance and distribute films. More importantly, the oligopoly structure remained intact in the distribution division of the industry, forever allowing the middlemen to continue extracting large profits from the weaker arms of the business.

Why CKEC is better than DWA

Long-time readers of this blog will know that I am bullish on CKEC, while bearish on DWA. This is because DWA occupies the least attractive arm of the industry, the production arm. Making movies is intrinsically a creative business, and creative industries are usually highly fragmented (see the fashion and IT industries), because ideas can and do arise in outsiders all the time. Production companies own libraries of films, but take outsized risks in making those films, and must share the revenues with gatekeepers like the distributors and Netflix/Amazon. Even worse, the Internet has driven down the cost of everything it has touched (see journalistic content, stock photography, online shopping etc.), and promises to do the same to movies. So, the future does not look bright for this part of the business.

A more attractive part of the movie business is the cinema owner arm, where CKEC resides. It is more attractive now than in recent history because the cinema chains have just gone on a massive consolidation spree in the 1990s and 2000s, and now has significant market share. The only problem, of course, is that they took on massive debt to consolidate, and now may not survive the hangover. But if they live past this crisis, it is likely that this part of the business will gain significant power and be able to push back somewhat against the distributors.

The most attractive part is, of course, the distributors themselves. But many are subsidiaries of major media conglomerates, so a pure analysis is difficult. And they never got cheap enough during the financial crisis to become a value investment, which isn’t surprising considering that their oligopoly status has been recognized for decades.

Disclosure : I have a long position in CKEC.

In my search for undervalued companies, I came across differing opinions for the value of Dreamworks (DWA). On the one hand, a professional analyst has rated DWA a sell, citing an EPS of only around $1 vs a stock price of around $16. On the other hand, two apparently independent financial bloggers, Frogskiss and Whopperinvestments, have come out with bullish calls on DWA, citing the deep library of films not carried on the balance sheet as the main reason why DWA should not be trading at close to book value, but rather way above book value. A difference of opinion is a potential profit opportunity, so I decided to do a little digging of my own. I was rooting for the bloggers (since I am one myself), but at the end of my analysis, I concluded that the analyst’s take is probably closer to the mark. For those who are interested, I set out my thinking below.

On DWA’s hidden asset

Hidden assets are the bread and butter of value investors. Many companies accumulate assets that are critical to their businesses but not well reflected on the balance sheet. A common example is land, which is typically carried at cost on the balance sheet, which can be vastly lower than its current market price. Typically, these hidden assets become important sources of value when the main business is failing and earnings fall off dramatically, but only when these hidden assets can be put to more productive use in another company’s hands. For example, a failing retailer with a lot of land can sell the land for residential or other uses, or a telco with a shrinking user base can sell excess wireless spectrum to other growing telcos. It is not clear to me that this is the case with DWA.

DWA’s hidden asset is its off-balance-sheet library of films, which contain such franchise films as Shrek, Madagascar, and Kung Fu Panda. These films cost $100-150M each to make, and were written down to zero when the films are released. However, the question that arises is, if the library is so valuable, why is DWA deriving only $80M of annual earnings from its library of content plus the 2 films it releases at the box office annually. DWA should be the company best able to monetize its own film library. If DWA is not able to monetize the library effectively, does that not mean that the library is not as valuable as anticipated? It seems unlikely to me that another company will be better able to monetize the library. Furthermore, film libraries are depreciating assets. With every year that passes, films become less valuable as memories fade and more competing films are made. Few films achieve evergreen status and continually generate a stable level of cash flow. With each year that DWA fails to monetize its content, chances are that the film library becomes less valuable.

On historical business models of movie companies

In the past, movie companies made films and released them in theaters, and the films had only 2-3 months in which to recoup their cost and make a profit at the box office. Box office earnings were everything to a movie. Then came VHS tapes, which allowed movies to be viewed at home on the TV. This increased the value of a film library, but only moderately, because the tapes were relatively expensive to manufacture, and picture quality degrades with time since the magnetic data was labile. The breakthrough technology came with the invention of the DVD, which costs pennies to make but retails for tens of dollars. Since the optical data was non-labile, for the first time, it was possible for the retail customer to acquire their own permanent personal movie library. The DVD revolution was further amplified because it coincided with the advent of the large screen LCD TV, the era of cheap credit. DVD, and the home theater craze. DVD earnings surpassed box office takings, and even decades-old films began to make serious money.

Then Armageddon struck in the form of Netflix, which made a personal movie library unnecessary. DVD sales has already began to decline. At this time, it seems inevitable that the DVD is headed for the trash bin of history, and the future of movie delivery is likely to be internet-based streaming. Blue-ray, the last best hope of the movie industry, has largely proved to be a dud. In the post-DVD streaming age, what is the likely value of DWA’s film library? Almost certainly lower than in the DVD age. In the best case scenario, Amazon may prove to be a viable opponent to Netflix, giving movie companies the possibility of a bidding war for their content library. However, Netflix has recently been laid low through its own missteps, and recently had to issue shares at a low price to shore up its balance sheet, and so is unlikely to be in a position to make rich bids for content. And Amazon, known as the Walmart of internet retailing, is unlikely to overpay for content. While the business model for internet streaming is still in flux, the final model is likely to be similar to the current model for theater delivery, that is, content companies receive a share of the revenue for each movie-viewer. In this scenario, cash flow from the film library will dramatically decrease, because while a large number of people may buy a DVD on the possibility that they may one day view the movie, in practice a far smaller number of people actually view the movie.

And matters could be worse. It is possible that executives at production companies have been misled by DVD earnings to splurge on their movie budgets. Certainly, the steadily rising movie budgets, now costing nearly $100-150M over 2-4 years for an animated film, suggests this. In other words, companies may have overpaid for their movies, and inventory write-downs will be required in the future. Furthermore, the large capital outlay makes companies more conservative. If you look at the upcoming slate of movies from DWA, they consist mainly of rehashes of their existing franchises (Kung Fu Panda 3, Puss in Boots 3 etc.). This paradoxically reduces the chances of getting a blockbuster movie.

My valuation for DWA

I predict that box office earnings will once again comprise the vast majority of film income, with only a trickle of cash flow from post-release streaming. Box office receipts are notoriously fickle and difficult to predict, so the earnings of movie companies will be lower and more bumpy. This means that the PE multiplier accorded should be lower. The professional analyst in question (Tony Wible, who also had the courage and foresight to correctly call the NFLX meltdown) gives DWA a PE of 12, for a price target of $12. I am more pessimistic and am personally inclined to give it a PE of only 10, for a $10 price target. As of Dec 15 2011, DWA had a shocking 37.7% of its float short, suggesting that many short-sellers are also of a bearish view. While I currently do not have a position in DWA, I am actively considering shorting it and other movie companies. To be sure, this is a highly hazardous short, since a blockbuster movie release could easily set off a massive short squeeze, so if you are thinking also of shorting this stock, I urge extreme caution. This is not for the faint-hearted, and certainly should not comprise a large portion of your portfolio.

A reader recently emailed me regarding a potential investment in a Japanese microcap stock, which set me thinking about Japanese stocks in general. Japanese stocks are really cheap right now. There are many Japanese stocks trading below book value. In fact, some stocks are trading below even the value of cash on their book. Yet Japanese stocks have been trading at depressed levels for close to a decade now, and show no signs of reviving. In a normal stock market, corporate raiders would have long ago taken over these companies and dismantled them for a profit. The problem, of course, is that the Japanese stock market, and indeed Japanese society itself, does not function normally. Foreign hedge funds have tried to shake up Japanese companies, but have been stymied by the Japanese courts. Basically, Japanese companies are not run for the benefit of their owners, but for their employees. In addition to the notoriously shareholder-unfriendly courts, the rapidly aging Japanese population and shrinking economy also puts a damper on valuations. And finally, interest rates have been scraping the bottom of the barrel for a decade now, and companies see no reason to turn to the stock market for capital when loans are so easily available. So really, there is no downside to treating shareholders like dirt.

Can all these obstacles be overcome? In my opinion, yes, but the timing will be tricky. The key to understanding the timing issue is to realize that the root of the Japanese problem is the generational struggle that is currently occurring. In short, Japanese society is run primarily for the elderly. The Japanese culture intrinsically respects the old, the old dominate leadership positions, and increasingly, the old are beginning to outnumber the young. Therefore, it is no surprise that Japanese society enacts policies that favors the old. Despite the demographic problems, the Japanese currency has been a safe haven for investors, because a hard currency favors the old. The Japanese yen has been flirting with deflation for a decade now, and young Japanese employees are used to seeing their wages go down every year rather than up, but this situation is perfectly acceptable to Japanese retirees, who see their expenditures go down while their savings stay up. Bonds are sacrosanct to the elderly, of course, and to protect bonds, companies will happily soak equity holders to keep cash on the books to preserve their credit ratings. Sometimes, of course, a Japanese company is just so badly run that the cash flow that supports the bonds becomes threatened. Nissan faced just this scenario in 1999, and a large foreign investor in the form of Renault had to be brought in. Renault took a controlling stake in Nissan, and its CEO Carlos Ghosn undertook a brutal cost-cutting campaign, laying off many young workers, while paying back its bonds in full within two years, and becoming that rare example of a foreign investor successfully taking over a Japanese company.

Demographic destiny cannot be denied, but it can be delayed. Currently, with the global financial crisis in full swing, Japanese bonds are in demand, and Japanese stocks are likely to continue to languish. It’ll take a sustained bout of inflation to wean the public off Japanese bonds. And when that happens, the pendulum will finally swing in the direction of the equity holders. Demographic trends move incredibly slowly, so I’m not about to invest in Japanese stock for now. But I am keeping an eye out for distressed Japanese companies, aiming to take a stake shorted after a foreign investor has gained a controlling stake.

After jeopardizing the nation’s credit rating, the US Congress is hard at work again with a new idea to destroy nascent recovery, this time from the Democrat side of the aisle. The law I’m referring to is the proposed enactment of tariffs against Chinese goods in retaliation for their currency manipulation. This is one of those measures that sound good on paper and in economic models, but anyone with any sense of realpolitik or history will realize that it is doomed to fail.

In fact, this particular movie has already been played before in the form of the Plaza Accord of 1985. In that instance, major world powers including the US found themselves at the losing end of an industrial race with Japan, and forced Japan to sharply increase the value of the yen. Japan, being dependent on the US for defense, had no choice but to agree, and soon the value of the yen soared more than 50%. To everyone’s surprise, the US-Japan trade deficit did not budge at all. This is due to both political and structural economic reasons. Politically, the Japanese government and public took great pride in their multinational car companies, and did everything they could to maintain their competitiveness. The government used unofficial quotas to protect the domestic car market, while at the same time flooded their economy with low interest rate loans to leverage them up to compensate for the decreased profit margins. Structurally, the Japanese method of assembling cars, using robots instead of humans, was simply a better way of making cars, and one which the Detroit car companies could not imitate due to their unions. Simply put, Japanese cars were superior in initial build quality, lasted longer, and had better resale values. The monetary intervention did nothing at all, except fan an enormous asset bubble in Japan which eventually imploded.

The Chinese have advantages in 2 types of goods, labor-intensive cheap goods, and surprisingly, capital intensive goods as well. That they have an advantage in labor intensive goods is a natural economic fact stemming from the huge Chinese population, and should not be something that is targeted by US trade policy. They also have an advantage in capital intensive goods as well (such as solar panels, which as Bronte Capital has pointed out, is the economic equivalent of paying for all your fuel costs up front), because the Chinese government is willing to print money to support their domestic green energy companies at non-economic interest rates. Tariffs on Chinese goods of say 25% will most likely affect the labor-intensive goods most severely. Under the best case scenario, assuming that the Chinese do not engage in retaliatory tariffs or measures, there will be a shift of the production of labor intensive goods out of Chinese hands and into another country (say Vietnam), which arguably might be more willing to import American goods, and therefore the US trade deficit will decrease. But notice even in the best case scenario, the effect on US trade deficit will be indirect and slow, and there will likely be an intervening period of adjustment as production ramps up in non-Chinese countries. And most assuredly, the Chinese are not going to stand pat and watch while we export unemployment to their shores. At minimum, you can bet that the stocks of GM and F are going to quickly resume their previous trajectory towards zero. In the worst case scenario, the US becomes the scapegoat as the Chinese asset bubble pops, and the two countries becomes engaged in all-out economic or, god forbid, actual war.

As an alternative to tariffs, I propose a China-America Investment Act, which gives tax breaks and market access to Chinese and other foreign countries who site their capital-intensive industries factories on US soil. This makes natural economic sense, because when you make large capital-intensive pieces of equipment like cars, solar panels and wind turbines, it is often cheaper to manufacture the end product as close as possible to the target market. Politically, the Chinese government wants to transform their large companies into true multinationals with large foreign sales, and also want to stop printing Chinese yuan given that domestic inflation is already topping the charts. Instead, the Chinese can redeploy some US currency from their mountain of US Treasuries into more productive assets, and give the US economy a much needed demand boost. True, when the factories are up and running, they will employ minimal numbers of workers, but they will be quality jobs which pay good wages, and the US is never going to find an edge in labor-intensive industries anyway. And in the meantime, while the factories are getting built, many laid off construction workers will be able to find jobs again. I think this is a more viable win-win strategy. Certainly, this is better than flirting with economic war.

Hewlett Packard, that icon of American technology, is now trading at between 5-7 times earnings. This is cheap, extremely cheap, especially for a large cap. Will new CEO Meg Whitman be able to turn things around? Sadly, I believe that the answer is : no.

Whitman, of course, led another technological icon eBay from 1998-2008. I had analyzed eBay previously back when I had a position in the stock a couple of years ago, so I had learnt something about Whitman’s management style. In short, Whitman is a visionary CEO, good at making grand strategic moves, but not good at the nuts and bolts of operations. In terms of strategy, Whitman is actually a passable CEO. She acquired two companies during her eBay stint, Paypal and Skype. The former acquisition is widely regarded as a success, and the latter a failure. However, the thinking behind both acquisitions was sound. Paypal was certainly a natural fit for eBay, and Paypal usage was probably boosted by its association with eBay. Skype can also arguably be regarded as complementary to eBay. After all, trust is important in online auctions, and a person-to-person conversation can do a lot to alleviate trust issues. However, Whitman overlooked a key operational detail during the Skype acquisition. She left the Skype’s key intellectual property in the hands of a separate company owned by Skype’s founders. Eventually, this allowed the Skype founders to continually blackmail eBay for more money, turning a marginally expensive acquisition into an incredibly expensive one. The greedy behavior of Skype’s founders was viewed with such disgust by the eBay management team that they did all they could to prevent Skype’s success, never incorporating Skype features into the eBay marketplace. While Whitman was busy with these transformative acquisitions, eBay experienced enormous organic growth due largely to the natural monopoly characteristics of the online auction business model. However, this growth was largely unmonitored and unguided by management, and eBay was widely criticized for its sale of stolen and illegal goods, the prevalence of fraudulent buyers and sellers, the clunky user interface and the widespread use of bidding robots. My impression was that nothing rose to the attention of eBay management until it has become widely reported by the media and threatened to become a legal issue. Contrast this with other online companies which has experienced exponential growth (Netflix, Amazon, Blizzard), where management proactively solved issues and generally kept its users happy despite massive growth in user base. In contrast, Whitman’s management team was almost solely focused on growth, especially growth overseas and through acquisitions, with little regard to the amount of money spent on acquiring growth. Post-eBay, Whitman campaigned to become California’s governor in much the same style, focusing on grand gestures and new directions while throwing money around with abandon. Whitman’s campaign was not successful, but is one of the most profligate campaigns of all time, spending nearly $45 per vote.

Of course, both vision and operational excellence are required for a company’s success. Every Steve Jobs needs his Tim Cook. My preference is that the Chairman takes on the strategic role, while the CEO concentrates on operations, but having a visionary CEO and a good COO is also fine by me. But tellingly, HP’s management team has no chief operations officer. This was inconsequential under Mark Hurd, since Hurd is himself an ops guy, but Whitman definitely needs a COO. While Whitman is no doubt trying to come up with some new magical acquisition or strategy that will fix everything, the underlying business is falling apart. Businesses and consumers are choosing Dell and Lenovo instead of HP for fear that HP will stop being in the hardware business soon. And if customers don’t trust HP with their hardware, where HP is a solid brand, I don’t think they will flock to HP enterprise software offerings any time soon.

HP does not have a transient difficulty due to the business cycle or a one-time mistake. It has an underlying management problem, one which I don’t see getting fixed. It is human nature to believe in oneself; few people are able to proactively acknowledge their weaknesses and seek help, and this is doubly true for someone as prone to grandiosity as Whitman. Yes, HP is an American icon. But no thanks, I think I’ll give this icon a miss.

Disclosure : No position in HP.

What a difference a couple of months makes in the ease of finding value stocks! Now that we’re awash with stocks trading at cheap valuations, what kind of stocks should one invest in? I humbly suggest Target, a stock that I think will hold its ground even in a double dip recession coupled with inflation, and will really take off if the economy stages a recovery.

The “Target will be driven out of business by Walmart” meme

Target is a familiar name to most US residents. The second-largest general merchandise retailer in the US (with 1750 stores exclusively in the US) had poor comparable stores sales during the recession, while its competitor Walmart posted better comparables. This led to phrases like “new normal”, and worries that Target customers were flocking en masse to Walmart. When comparable stores sales at TGT rose only 0.9% in January 2011, below the average for most other retailers, investors’ worst fears were apparently confirmed, and the stock staged a rapid 25% decline to the $45-50 range. This decline was probably accelerated by Bill Ackman puking out shares after a failed campaign to get Target to monetize its real estate holdings.

Competent retail analysts are aware that Target and Walmart are not, in fact, in direct competition. The two companies have different business models. Walmart strives for scale and operational efficiency, stocking less SKUs and maximizing inventory turns, appealing to its price sensitive and utilitarian shoppers who know what they want and want to get it at the lowest price. Target’s business model is akin to Costco’s, selling high quality merchandise in a pleasant shopping environment at low margins, while making more profit from shoppers who make discretionary impulsive purchases while browsing the store. Target’s consumers have retrenched during the recession and are doing less discretionary shopping, leading to lower comparables, but are still shopping for the essentials, an area where Target’s and Walmart’s prices are much closer. Shopping turns out to be a surprisingly sticky activity. Target is not losing customers; rather, its customers are changing their shopping habits in the face of the tough economy. Target management is aware of customers’ cash flow problems, and has rolled out the REDcard credit card initiative, which gave customers a 5% discount for shopping at Target, to huge success. Target also has a very low cost base, owning most of its stores outright and therefore not having to pay leases. These factors have led to Target staying in the black throughout the recession despite poorer profitability. I believe that Target’s customers have already retrenched all that they can, and that sales at Target have reached their nadir. Walmart’s growth coincided with a flood of low-cost imports from China, a phenomenon that likely has run its course, given rampant cost inflation in China, and going forward, Walmart’s customers are likely to find more pricey products and a higher incentive to try out Target stores. Going forward, investors will also see that the declining situation at Target has stabilized. More recent data bear this out, with Target’s August 2011 comparables up 4.1%. It is important to note that even if comparable sales do not take off and stay at this depressed level, Target is nevertheless profitable.

Target’s excellent growth prospects

Target has yet to saturate its core domestic market. Walmart has some 3000-4000 stores in the US, while Target has a relatively paltry 1750 stores. Management expects that an expansion to 2500-3000 stores is reasonable in the US market.

Target has also rolled out the P-Fresh concept, selling fresh groceries in stores. This is not expected to add to margins, because groceries are a low margin product, but does result in a 6-7% bump in overall sales in stores where the concept has been rolled out. Presumably, when the market recovers, this will translate to additional shoppers who will contribute to high margin discretionary purchases. While rolling out the P-Fresh concept will cost an estimated $1.8B, the returns are sufficiently high that this will add to growth, especially in a market recovery.

In addition, Target has announced plans to expand into the Canadian market, where it already has high brand awareness from spillover US advertising despite no retail presence. It has recently purchased 220 Zeller’s retail locations for $1.8B, with its first Canadian stores slated for 2013.

Target’s many assets

Property. Target owns 1500 of its 1750 stores. This was the prize coveted by Bill Ackman when he acquired a large block of Target shares during the peak of the real estate bubble, and subsequently tried to force management to spin off the real estate holdings into a separate company and to lease back those stores, thereby “unlocking” value. The popping of the real estate bubble put a crimp in that plan. Now, the value that Ackman’s prize is Target’s competitive advantage, dramatically lowering its operating costs compared to competitors, and helping Target remain profitable in a downturn.

A near impregnable market niche. The moat around Target’s niche is demonstrated by the fact that Walmart once launched a campaign to take market share from Target, but the appearance of high cost products in their stores only caused dismay among its customers and a dilution of Walmart’s brand. The project was later unceremoniously canceled, and replaced with a new campaign to try to raise margins with Walmart’s existing customers. Target’s scale allows it to underprice all other competitors aside from Walmart, and allows it to test out new concepts in select regions before rolling them out to all stores.

Goodwill. Target has enormous brand awareness and goodwill among both customers and suppliers. Suppliers desperately need a retailer of scale aside from Walmart, which has been relentlessly squeezing them on costs, and therefore are more likely to give Target preferable pricing. Among customers, Target’s brand awareness is very high. Target shoppers know that while they will not get the absolute lowest prices, they will have a better shopping experience with a larger selection and good value.

Capable management. Target’s management is known for competence in retailing and financial conservatism. They put a lot of effort into making browsing a pleasurable experience for the shopper, while balancing the need to simultaneously provide a good value proposition. The REDcard and P-Fresh concepts are evidence that management is not resting on its laurels, and are constantly trying to find ways to increase comparables. In addition, Target management is financially conservative, rejected Ackman’s financial engineering ploy as a way to boost earnings, and generally taking a measured conservative approach to growth. While Walmart expanded aggressively into many international markets simultaneously during the boom, and had to retreat from several of those markets eventually, Target had stayed an exclusively US retailer, expanding slowly and preferring to acquire stores in cash rather than through debt. Management has only recently started to get aggressive about growing store count, taking advantage of the low costs to expand into Canada. TGT therefore has a lower debt-to-equity ratio than WMT, with long-term debt adding up to less than half of equity.

Summary of investment thesis

As a general merchandise retailer, Target is likely to be able to pass on inflation costs to its customers, and therefore serves as an inflation hedge. While currently experiencing depressed profitability, Target’s customers are expected to loosen the purse strings if the economy improves. Furthermore, Target’s current growth initiatives are also expected to bear fruit in a recovery economy. At a share price of $50, TGT has a market cap of $36B, or about 12x trailing free cash flow of about $3B, TGT is a stock with minimal downside but poised to explode on the upside with any recovery. Note that TGT has managed to grow the bottom line by nearly 10% annually through the recession, and sports a dividend of 2%.

The only fly in the ointment is that the huge success of the REDcard initially has resulted in credit card earnings making up a significant portion of the total revenues, as well as credit card receivables making up a large portion of the balance sheet. There is some concern that as a company without extensive experience in the credit card business, TGT may have mispriced its receivables. However, Target is expected to sell its receivables to a financial company in the future, a step which should bring in cash for its current expansion, as well as clear up any misgivings about the valuation by bringing in an independent set of eyes. This will also turn TGT into a pure play retailer once again, which would make it easier to analyze for retail analysts.

Disclosure : I have a long position in TGT.

In his latest NYT column, Floyd Norris joins a rising tide of pundits in pushing for higher inflation. There are two main lines of argument for higher inflation. Firstly, the economy is too leveraged, many people have underwater mortgages and cannot spend, therefore decreasing the real debt burden will boost the economy. Secondly, deflation is bad for the economy, therefore inflation must be good. The premises of both lines of argument are true, but the conclusion may well be false.

The fundamental problem is a failure to consider the costs of inflation alongside the benefits. Yes, increasing inflation will likely lead to an uptick in real estate prices, which may lead to fewer underwater mortgages. But will this really lead to a recovery in consumption? What other effects might inflation lead to? Do you really think rich asset holders simply sit tight and let the central bank erode away their wealth? The most benign effect of inflation will be to raise home prices. There are a variety of other much more adverse side effects. For example, rich investors can snap up farmland as an inflation hedge, and then demand increasing farm rents to offset inflation erosion, resulting in rising food prices. Wages, I expect, has no chance of rising with the current sky-high unemployment rate, which would result in lower- and middle-income classes getting squeezed, and maybe abandoning all other discretionary luxury purchases. There could be increased capital flight from the US, leading to a decrease in productive investment. By pushing investors into deploying their cash, the economy as a whole may see all their real assets further concentrated in the hands of the moneyed classes, which can then just sit on their assets and demand rents from the rest of the economy. On balance, I think that the possible distortions brought on by inflation will probably outweigh the benefits. Paul Krugman has also recently pointed out that there is good inflation, and then there is bad inflation. It is far from clear what type of inflation will be stoked if one just prints more money.)

In a modern efficient capitalist economy, financial factors, such as an appropriate amount of money in circulation and a financial sector that allocates capital rationally, cannot in and of itself CREATE economic growth. At some point, capital flow is as lubricated as can be, and increasing the size of the financial sector past that point just creates a source of instability. Simply printing money will just cause people to shuffle money around the various asset classes without actually increasing the stock of economic assets. What we need now is joint financial-government action, with the central bank keeping interest rates low so that the government can borrow cheaply and invest in increasing the stock of economic assets, and the central bank also printing money to match the increased stock of economic assets so that deflation doesn’t occur. Avoiding deflation is critical, but that does not mean that one should advocate for inflation. In other words, it is time for the government to step up.

I pondered this question as I drove back from work some hours ago. After months of difficulty finding bargain stocks, the incredible one day 7% drop in the stock market over the past 12 hours, combined with the decimation that occurred over the last week, has finally brought many stocks into value territory. But as soon as one difficulty was solved, another arose. How can I take advantage of a possibly fleeting drop in prices, with so many possible stocks and so little time? I have a modest database of several hundred stocks that I have previously investigated in detail, but if I am to place my orders the next trading day, there is not enough time to carefully peruse the latest stock-specific news. Clearly, some kind of quick-and-dirty statistical measure of value will have to be substituted for the usual carefully poring through the annual reports. Through a selection of 20-30 stocks based on some crude measure of value (I’m leaning towards free cash flow multiple), I can hedge against the few bad calls that will probably occur. I intend to place an additional 20% of my portfolio to this strategy, using margin to do so.

I discussed my plans over dinner with the wife, and was asked the inevitable question: What if the stock market falls further? I answer that since we cover all living expenses from my salary and have no need to draw on our investments, and that we are only moderately leveraged through margin, it is highly unlikely that we will meet a cash crunch or a margin call and be forced to liquidate. But in the back of my mind, I am debating the question, is the stock market really the best asset class now? What asset class will best be able to withstand even a double dip recession? Gold is clearly the asset du jour, but I am uncomfortable with an asset with no intrinsic value and negative carry costs, necessitating careful daily tracking of the price to ensure that I do not miss the popping of the bubble. Timberland, farmland and real estate are attractive, and I intend to try and include some REITs in my portfolio. Holding cash or bonds with their extremely low yields is unattractive to me, given that interest rates are at record lows, and not sufficient to compensate for possible default. I would rather hold blue-chip dividend paying companies that can clearly survive a recession.

As I write this, I am racing the clock to complete my portfolio selection before the market opens. I’ll be leaning towards dividend paying stocks, but since minimal analysis would have been done, I’ll probably treat it as a basket of stocks, and report the overall gain/loss based on the entire basket on this blog some time in the future. But for now, I need to buckle down and do some stock selection.

P.S. The Obama administration is clearly clueless about what is driving the markets. The S&P downgrade itself is a non-event, as evidenced by the flooding of funds into Treasuries. It is the reaction to the downgrade, with the possibility of extreme fiscal austerity tanking the economy, that has the market spooked.